QE2 Drowning TIPS Yields Below Water

The holiday season is creeping up on us, and the only question building up more anticipation than what gift kids are going to get from Santa Claus is what investors are going to get from Federal Reserve Chairman Ben Bernanke – in the form of QE2 (Quantitative Easing Part II)? The inevitable QE2 program is an effort designed by the Fed to keep interest rates low and reduce the threat of deflation. In addition, QE2 is structured to stimulate the meager 0.8% core inflation experienced over the last 12 months (Bloomberg) to a Goldilocks level – not too hot and not too cold. Some pundits suggest the Fed should target a 2% inflation rate. QE2 asset purchase estimates are all over the map, but I can safely guess somewhere between a few hundred billion and $2 trillion (very brave of me).

Treasuries Weigh Down TIPS Yields

Ever since QE1 expired in the March timeframe, speculation began about the next potential slug of Treasuries and mortgage backed securities to be purchased by the Fed. As a consequence, this speculation became a contributing factor to 10-Year Treasury yields plummeting from around 4.0% to around 2.5%. Simultaneously, 5-Year TIPS (Treasury Inflation Protection Securities) yields have moved to negative territory.

Scott Grannis at Calafia Beach Pundithas a great chart showing the relationship between nominal Treasury yields, real TIPS yields, and expected inflation for 10-year maturities. As you can see below, over the last ten years there has been a tight correlation between the 10-year Treasury bond versus TIPS, with the former 10-year declining yield acting as a weight drowning the latter TIPS yield:

Source: scottgrannis.blogspot.com

Worth noting, absent the brief period in late-2008 and early-2009, inflation expectations have been remarkably stable in that 1.5% – 2.5% range.

Negative Yields…Who Cares?!

Unprecedented times have created an unprecedented appetite for bonds (see Bubblicious Bonds), and as a result, we just witnessed a historic $10 billion TIPS auction this week producing an eye-catching negative -0.55% yield. Sensationalist commentators characterize the negative yield dynamic as a money losing proposition, whereby investors are forced to pay the government. This assertion is quite a distortion and not quite true – we will review the mechanics of TIPS later.

Source: scottgrannis.blogspot.com

If we’re not back to a panic filled environment of soup kitchen lines and bank runs, then why are TIPS paying a negative yield?

QE2: As mentioned above, investor expectations are that Uncle Sam will come to the rescue and deliver lower interest rates (higher prices) through purchases of Treasuries and mortgage-backed securities.

Rising Inflation Expectations: As fears surrounding future inflation increase, the price of TIPS will rise, and yields will fall.

Sluggish Economy: Lackluster growth and fear of double dips have pressured rates lower as debates still linger about whether or not the U.S. will follow Japan (see Lost Decade).

Nuts & Bolts of TIPS

TIPS maturities come in terms of 5 years, 10 years and 30 years. Per the Treasury, 5-year TIPS are auctioned in April and October; 10-year TIPS in January, March, May (beginning in 2011), July, September, and November; and 30-year TIPS in February and August.

This table from Barclays Capitalbelow does an excellent job of conceptually displaying the differences between vanilla Treasuries and TIPS.

Some Observations:

1) As you can see, the principal value of the TIPS security adjusts with inflation (Consumer Price Index). The price of the TIPS security, which we cannot see in the example, adjusts upwards (or downwards) with inflation expectations.

2) The TIPS security pays a lower coupon (3.5% vs. 5.0%), but you can see that under a 4% annual inflation assumption (principal value adjusts from $10,000 in Year 0 to $10,400 in Year 1), the ending value of the TIPS comes up significantly higher ($19,172 vs. $15,000).

3) The break-even inflation expectation rate is 1.5% (derived from 5% coupon minus 3.5% coupon). If you think inflation will average more than 1.5%, then buy the TIPS security. If you think inflation will average less than 1.5%, then buy the 10-year Treasury.

TIPS Advantages

Inflation Protection: At the risk of stating the obvious, if you expect long-term inflation to average substantially more than about 2% (current inflation expectations), then TIPS are a great way of protecting your purchasing power.

Deflation Protection: Perhaps TIPS should be called DIPS (Deflation Income Protection Securities)? What some investors do not realize is that even if our country were to spiral into long-term deflationary crisis, TIPS investors are guaranteed the original amount of principal. Yes, that’s right…guaranteed. Interest payments could conceivably decline to zero and the principal value could temporarily fall below par, but the government guarantees the original principal regardless of the scenario.

No Credit or Default Risk: The advantage of the government owning its own printing press is that there is very little risk of default, so preservation of capital is not much of a risk.

TIPS Disadvantages

Interest Rate Risk: It’s great to be indexed to inflation, but because TIPS include long-range maturities, investors face a significant amount of interest rate risk if the TIPS are not held until maturity. TIPS will likely outperform Treasuries under a rising rate scenario, but will be impacted nonetheless.

CPI Risk: Even if you are not a conspiracy theorist who believes government CPI figures are artificially depressed, it is still quite possible your personal baskets of purchases do not perfectly align with the arbitrary CPI basket of goods.

Negative Deflation Adjustments: Although a TIPS investor has an embedded “deflation floor” equivalent to original principal value, interest payments will be negatively impacted by declines in principal value during deflationary periods. Also, previously issued TIPS with accumulated principal values from inflationary adjustments run larger principal loss risks as compared to newly issued TIPS.

Although 5-year TIPS yields may have dunked below water into negative territory, the headline bark is much worse than the bite. There has been a massive rally in bond prices in front of the QE2 bond binge by the Fed. Nevertheless, inflation expectations have remained fairly stable and TIPS still provide defensive characteristics under both a future inflationary or deflationary scenario. If the Fed is indeed successful in manufacturing a reasonable Goldilocks range of inflation then TIPS yields should once again be able to come up for air.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.